Lecture 6 A touch of Macro

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Lecture 6A touch of Macro

• Introductory Economics for the Treasury
• Dr. Paul Frijters
• http//econrsss.anu.edu.au/frijters

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Outline of this lecture

• 1. Long-term growth patterns
• 2. Long-run capital formation
• 3. Cycles Keynesianism
• 4. Cycles Creative destruction
• 5. Cycles Money and cycles
• 6. The effect of other countries

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Long-term growth

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Business-cycles in Australia

Source Maddison (2003)
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Sources of long-term growth

• Basic argument in the long run, you consume as
  much as you produce. Your productivity depends on
  your stocks of capital and the presence of
  economies of scale. More capital, higher levels
  of material welfare.
• 1. Physical capital
• 2. Human capital
• 3. Natural capital
• 4. Institutional capital
• 5. Social capital

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Physical capital

• Machines, buildings, roads, etc.
• How do you become wealthier in this view
  (Swan-Solow model) you invest more.
• Means of investment high personal saving rates,
  government saving, or borrowing from abroad.

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Human capital

• Knowledge of the optimal use of other production
  factors.
• How to grow educate, train, disseminate
  productive information via tv or other media.
• Essentially time investments of parents,
  children, and the government.

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Natural capital

• Land, oil, minerals, climate.
• How do you get more? The only way is to take from
  others.

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Institutional capital

• The degree to which institutions reduce the cost
  of and stimulate others to acquire more capital.
• Ways to acquire more introduce rules and laws
  that give optimal incentives foster attitudes
  and loyalties that minimise rent-seeking acquire
  and disseminate information (use economies of
  scale).

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Social capital

• Trust, contacts, community cohesion, shared
  expectations and norms that reduce the need for
  formal contracting.
• How to create more we dont really know.
  Guesses cohesion comes from socialisation and
  common enemies shared expectations evolve by
  exposure and the availability of information.
  Contacts (between production factors) get formed
  by time-investments. Essentially social capital
  formation interacts with institutional capital
  (costs, incentives).

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Economic cycles basic terms
Economic fluctuations in the short-run
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(neo-)Keynesianism

• Take the following stylised representation of a
  market economy

farmer Baker
Normal situation aggregate demand and
aggregate supply are in balance
Engineer
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Keynesian recession

• 1. Producers are pessimistic suppose the baker
  fears her products will not be bought, so she
  refuses to buy from the farmer

farmer Baker
Engineer
Result the farmer cannot buy from the engineer,
then the engineer can buy less from the farmer
trade suffers.
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Essential ingredients

• 1. The farmer and the engineer and the baker may
  not share exactly the same expectation they may
  be surprised by the actual actions of others and
  have excess production capacity as a result.
• 2. The pessimism of the baker may be
  self-confirming she expects to get less demand
  and in the end, she does (multiple equilibria).

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Policy response

• 1. Reaganism talk optimistically.
• 2. Demand management fuel the economy by
  borrowing from each actor. One possibility
  simply buy from farmer, baker, and engineer.
  Other possibility low interest rates such that
  individuals borrow a lot and save little or fuel
  housing market such that individuals borrow more.
• 3. Combination (actual Reagan policy) talk
  optimistic and induce government or private
  borrowing.

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Eternal problems

• 1. Though most economist are convinced there is
  something plausible about the possibility of
  coordination breakdown, it has appeared
  politically impossible so far to save up in booms
  to spend in recessions.
• 2. Any borrowing boom will cease in the end to
  borrow for extended periods is simply inviting a
  larger recession afterwards.

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Creative destruction

• Stylised initial situation

farmer1 Baker1
farmer2 Baker2
Engineer1
Engineer2
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But

• The following configuration is actually more
  productive due to economies of scale

farmer1 Baker1
farmer2 Baker2
Engineer 1 and 2 swap
Engineer2
Engineer1
Low-productive
High-productive
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How does this come about?

farmer1 Baker1
farmer2 Baker2
Engineer1
Engineer2
High-productive engineer 2 leaves former partners
and replaces Engineer 1, who is stranded and
without partners recession
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recovery

farmer1 Baker1
farmer2 Baker2
New connection
New connection
Engineer2
Engineer1
The stranded trading partners find each other and
form new productive circle boom
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Ingredients

• 1. It takes time to find, recognise and take
  opportunities for advantage.
• 2. The actions of engineer 2 have adverse
  consequences for farmer 2, baker 2, and engineer
  1 they lose out.
• 3. It is the more productive connections made
  during the recession which form the basis for
  overall growth.

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Question

• Is there any inherent reason why firms /
  individuals / organisations would coordinate
  their replacement of unproductive contacts at
  the same time and thereby have an economy-wide
  recession?

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Answer

• When the rest invests in more productive
  connections, it is in your interest to do so also
  because contacts last less long during recessions
  (the cost of breaking them is lower).
• It is easier to find others when others are
  looking for new contacts also everyone searches
  better connections at the same time for exactly
  the same reason that people coordinate leisure
  activities.

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Implication

• - Its in the long-run interest to allow creative
  destruction to happen let old connections and
  technology disappear and have incentives to take
  opportunities (property rights, patents).
• - Information exchange is at the heart of the
  rate at which new opportunities are recognised
  and taken.
• - Recessions are in some sense productive
  investments in the future.

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Question

• Are fluctuations avoidable?
• 1. Under Keynesianism perhaps indeed by demand
  management.
• 2. Under Creative Destruction no, because a
  recession is actually the time when the old ways
  die en masse to make way for the new. No
  recessions, no long-term growth.

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The role of interest rates in cycles

• 1. When the real interest rate is low
• - the pay-back on savings is low and hence
  consumption will increase.
• - the costs of borrowing are low and hence
  various forms of borrowing will increase, again
  fuelling consumption.
• Hence low interest rates increase aggregate
  demand.

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Money.

• When the amount of money in the economy is
  increased
• - individuals have more notes to spend and are
  likely to demand more higher aggregate demand.
• - because production is determined by
  productivity which is rather sluggish, a faster
  increase in money than in productivity will lead
  to inflation.

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Money and cycles

• You can create an artificial boom by setting
  interest rates very low or simply increasing the
  money supply.
• But .
• In the end, low interest rates lead to lower
  aggregate savings which means less investment in
  the future which means eventual slowdown in OWN
  consumption.

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Money and cycles 2

• And.
• More money supply leads to (unexpected) inflation
  which ultimately leads to a breakdown in economic
  relations money loses its role, which means a
  return to more primitive and less efficient means
  of exchange, and relative prices change fast and
  unexpectedly meaning a reversal of
  specialisation. The savings collapse may have
  political repercussions as well.

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An open economy

• An open economy is one with large trade and
  capital flows with other countries.
• Australia is an open economy.
• The US, the EU, and some other large entities
  trade mostly with themselves and can be seen as
  in between an open economy and a closed economy.

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Effects of being open

• 1. On waves of pessimism (Keynesianism) foreign
  events may be a focal point for expectations
  here.
• 2. On demand fluctuations a recession abroad
  means less demand for home products, which is a
  transmission mechanism of foreign fluctuations.

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Effects

• 3. On creative destruction foreign recessions
  can trigger a wave of re-allignments if foreign
  firms / organisations are part of the current set
  of traders.

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Effects

• 4. On money fluctuations if one can with little
  cost invest abroad, money will flow to where its
  return is highest which limits the effect of
  setting home interest rates to the importance of
  local borrowing. Being open reduces the
  importance of home interest rates (foreign
  lenders can come in) and exposes one to
  volatility in savings elsewhere.

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And so

• - Being an open economy limits the effect of home
  interest rate policy and home demand management.
  For good or for bad.
• - Leads to synchronised fluctuations under all
  major theories of cycles.

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Recap of the last two weeks

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Key economic ideas

• 1. Competition (Adam Smith 1776)
• 2. Functioning markets
• 3. Benevolent rule setters
• 4. Homo Economicus (economic man)
• 5. Equilibrium
• 6. Money Circulation
• 7. Creative Destruction

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Complements or substitutes?

• In production
• Two inputs are seen as complements when one input
  raises the productivity of the other input.
  Examples a computer and a worker, a sales
  department and a production department, a soldier
  and a gun, nuts and bolts, income tax laws and
  tax collectors, tertiary education systems and
  RD.
• Two inputs are seen as substitutes when one input
  reduces or has the same function as the other
  input. Examples a computer and a typewriter, a
  combine harvester or low-skilled labour.

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Rules of thumb

• 1. High-skilled labour and capital are generally
  complements. Implication high-skilled labour
  profits from a low price of capital.
• 2. Low-skilled labour and capital are
  substitutes. Implication low-skilled labour
  suffers from a low price of capital.
• 3. Different specialisations are generally
  complements. Implication a higher degree of
  specialisation increases production.

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The basic point about networks

• First 4 points, 4 connections. Each point can
  travel to 3 others 12 point-destinations, 3
  point-destinations per node.

Second 5 point, 5 connections 20
point-destinations with only 1 More connection,
i.e. 8 point destination at a cost of 1 node more
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Rules of thumb

• 1. On the country level, production is generally
  believed to be constant returns to scale (i.e.
  there is no inherent reason why a small country
  is generally more or less productive than a
  bigger one).
• 2. Manufacturing, network industries (mobile
  phones, basic software), and communication
  vehicles (languages) are generally believed to
  have increasing returns to scale.
• Specialised professional services (accounting,
  law, consulting, engineering) are generally
  believed to quickly suffer from decreasing
  returns to scale.

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Economies of scale in the state

• 1. Economies of scale of information gathering
  it is very costly to set up an organisation that
  can continuously keep track of one person, but
  keeping track of the next persons becomes
  progressively easier.
• 2. Economies of scale of violence to be able to
  punish one person anywhere is costly. To be able
  to do so with many becomes cheaper.
• These are actually both examples of the economies
  of scale inherent in networks

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Consumer and Producer Surplus in the Market
Equilibrium
Price
Consumer Surplus
Supply
Equilibrium price
Producer Surplus
Demand
0
Quantity
Equilibrium quantity
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Elasticity and tax

• Questions
• how does tax change the quantity of good traded
  depending on price?
• Who bears the tax burden?
• When is it easiest to raise taxes?

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Elastic Supply, Inelastic Demand
Price
Supply
Tax
Price without tax
Demand
Quantity
0
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Elastic Supply, Inelastic Demand
Price
Price buyers pay
Supply
Tax
Price without tax
Price sellers receive
Demand
Quantity
0
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Elastic Supply, Inelastic Demand
Price
1. When supply is more elastic than demand...
Price buyers pay
Supply
Tax
Price without tax
Price sellers receive
Demand
Quantity
0
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Elastic Supply, Inelastic Demand
Price
1. When supply is more elastic than demand...
Price buyers pay
Supply
2. ...the incidence of the tax falls more heavily
on consumers...
Tax
Price without tax
Price sellers receive
Demand
Quantity
0
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Elastic Supply, Inelastic Demand
Price
1. When supply is more elastic than demand...
Price buyers pay
Supply
2. ...the incidence of the tax falls more heavily
on consumers...
Tax
Price without tax
Demand
Price sellers receive
3. ...than on producers.
Quantity
0
Note the change in quantity is smaller when
demand is less elastic. Hence also the loss in
total surplus.
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Inelastic Supply, Elastic Demand
Price
Supply
Price without tax
Demand
Quantity
0
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Inelastic Supply, Elastic Demand
Price
Supply
Price without tax
Tax
Demand
Quantity
0
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Inelastic Supply, Elastic Demand
Price
Price buyers pay
Supply
Price without tax
Tax
Demand
Price sellers receive
Quantity
0
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Inelastic Supply, Elastic Demand
1. When demand is more elastic than supply...
Price
Price buyers pay
Supply
Price without tax
Tax
Demand
Price sellers receive
Quantity
0
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Inelastic Supply, Elastic Demand
1. When demand is more elastic than supply...
Price
Price buyers pay
Supply
Price without tax
Tax
Demand
Price sellers receive
2. ...the incidence of the tax falls more
heavily on producers...
Quantity
0
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Inelastic Supply, Elastic Demand
1. When demand is more elastic than supply...
Price
Price buyers pay
Supply
Price without tax
3. ...than on consumers.
Tax
Demand
2. ...the incidence of the tax falls more
heavily on producers...
Price sellers receive
Quantity
0
Note the change in traded quantity is lower when
supply is less elastic.
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Tax Distortions and Elasticity
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Tax Distortions and Elasticity
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Market failures

• 1. Coordination by suppliers or monopolies.
• 2. Asymmetric information, moral hazard.
• 3. Externalities, public goods.